Archive for September 2010

Here is Paul Krugman, right after I did a really nice post praising him:

Brad DeLong manfully takes on the efforts of various commentators to define away the paradox of thrift and redefine our current problems as somehow wholly monetary. As I see it, this is all a desperate attempt to cut and stretch things into a quasi-monetarist framework, for no good reason.

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So what’s wrong with my “one model to rule them all”? Well, it doesn’t easily translate into anything that looks like monetarism — for a good reason: when short-term interest rates are near zero, the distinction between the monetary base, which the central bank controls, and the much broader class of safe short term assets, which it doesn’t, more or less vanishes. That’s not a bug, it’s a feature; it says that when you’re in a liquidity trap, thinking in terms of the supply and demand for money is just not a helpful way to approach the issues.

Let’s start with some propositions that all us new Keynesians and quasi-monetarists can agree on:

1. If interest rates are 5% and the Fed announces a doubling of the money supply, and also announces that all the new money will be pulled out of circulation a month later, almost nothing will happen to prices and output.

2. If interest rates are 0% and the Fed announces a doubling of the money supply, and also announces that all the new money will be pulled out of circulation a month later, almost nothing will happen to prices and output.

3. If interest rates are 5% and they announce a permanent doubling of the monetary base, prices will rise sharply.

4. If interest rates are 0% and the Fed announces a permanent doubling of the money supply prices will rise sharply.

Monetary policy is never very effective if the injections are temporary, and (almost) always very effective if permanent. (Unless the liquidity trap is expected to last forever.) So the problem during a liquidity trap isn’t really that cash and T-bills are perfect substitutes, it’s more complicated.

So what’s the real issue here? Unfortunately, just like in the game “wack-a-mole,” a new objection pops up as soon as you answer the previous one. A little history might be helpful. For decades the new Keynesians have been driving the economy using a flawed interest rate instrument. They got away with it until rates hit zero. Now they are looking for answers. The quasi-monetarists are suggesting that the Fed increase the supply of base money (QE) and/or reduce the demand for base money (lower IOR and higher inflation targets.) The more progressive new Keynesians like Krugman support these ideas, but get bent out of shape when quasi-monetarists try to define our AD shortfall problem as essentially monetary, rather than simply an implication of the paradox of thrift. [BTW, I prefer autistic to Procrustean.]

So what are the issues that separate us?

1. The quasi-monetarists have higher expectations for monetary policy. We all agree the Fed could do a lot more. We all want them to do a lot more, but only the quasi-monetarists actually assume that the Fed is still driving the car, still determining NGDP growth.

2. Communication. The new Keynesians drove the economy off the cliff, yanked off the steering wheel, handed it to the quasi-monetarists, and said “OK, you drive smarty-pants.” But at the zero bound driving the economy requires a whole new form of communication. We can’t use interest rates and the markets aren’t used to anything else. Remember, only permanent money supply increases are effective. But since base demand is so unstable at low rates, we can’t really target the base credibly; it would leave prices too unstable. [That’s why we’re quasi-monetarists, not monetarists–we don’t assume stable money demand.] So we have to combine changes in the money supply with changes in the inflation target. We need to tell the public we’ll inject enough money to push prices X% higher over the next few years. The new Keynesian will respond “Aha, but that’s not monetarism, that’s new Keynesianism. The inflation target is doing all the work, not the money supply increase.” Yes and no. It is mostly the target, but not completely. That’s because the Keynesian liquidity trap model is slightly unrealistic in several ways:

a. The Fed can limit reserve demand by cutting rates on bank reserves to zero, or negative. In that case it’s all about cash held by the public. And the reasons people hold cash are different from the reasons they hold securities. Most cash is held for tax evasion and petty transactions–neither of which can be easily done with T-bills. So they aren’t quite perfect substitutes. Still, rates on T-bills could go negative enough to make them near perfect substitutes.

b. Cash is even less of a perfect substitute for other types of securities, which the Fed could also purchase.

c. Most importantly, QE is also a form of communication. If you are trying to convince markets that you are adopting a more expansionary monetary policy, it is easier to do if you both announce a higher inflation target, AND ALSO DO SOMETHING. Roosevelt understood this, which is why he adopted a gold buying program in late 1933. The amounts of gold purchased were far too small to have any macro effect, but nonetheless the program did move market prices. Why? Because it was a signal that FDR was soon going to do something which would be effective—permanently devalue the dollar. He bought gold at higher and higher prices, which was a signal to the markets about the likely future price of gold. QE would be Bernanke’s gold-buying program, only slightly effective on its own, but very powerful when combined with a higher inflation target. Even if the inflation target isn’t explicit, but merely hinted at.

It’s slightly annoying the way people like Krugman and DeLong imply their opponents don’t understand the paradox of thrift. Yes, if people try to save more, and rates fall, the real demand for base money will rise. And if the Fed doesn’t offset that then AD will fall. We do understand that. But we continue to insist the problem is fundamentally monetary because we see the Fed as being able to offset any shifts in public or private saving. And how can Krugman disagree with that on theoretical grounds? Hasn’t he just been hammering the Fed for not doing enough to boost AD? It’s a bit late to claim the Fed can’t do anything when rates are zero. Now he’s certainly entitled to claim that he doesn’t think the Fed would completely offset an attempt by the public to save more, or a program of austerity by the government, but that’s an empirical judgment. It has nothing to do with new Keynesian theoretical models that supposed “prove” there is a paradox of thrift at the zero bound.

The paradox of thrift models are only pulled out at the zero bound, because that’s when monetary policy is (allegedly) ineffective. So you have the bizarre spectacle of Krugman castigating the Fed every Monday, Wednesday, and Friday for not doing enough, and then on Tuesday and Thursday criticizing economists who don’t believe in the paradox of thrift—a model that only makes sense if the Fed can’t do anything!

As for Mr. DeLong, his reply to Nick Rowe’s comment is fine as far as it goes, but it doesn’t go anywhere near deeply enough into the problem. No one is asking the Fed to merely do a few desultory OMOs, and then imply they’ll soon be reversed. And at times he still seems to be struggling to free himself from the influence of 1930s Keynesianism, as when he claims the problem can’t be monetary, because interest rates on government bonds aren’t very high:

Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds–which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange.

I wish we could stop all this skirmishing on side issues, and focus on what really separates us–whether it is most useful to think of monetary policy driving inflation and NGDP growth, even at the zero bound. Or whether (as Krugman and DeLong seem to believe) it is more useful to think of monetary policy as passive and ineffective at the zero bound, and do macro analysis on that assumption. They’re entitled to that belief, but then I don’t see why the Fed should listen to their complaints that money’s too tight.

One final comment. Keynesians argue that only permanent monetary injections matter at the zero bound, and thus that it is pointless to increase the current money supply. But that’s true equally true of interest rates in normal times. If you raise rates 1% and announce they’ll be cut again a month later, almost nothing will happen. Woodford showed it’s all about the expected future path of policy. So this argument that current changes in the money supply are not important is always approximately true, and equally true of interest rates. Plan on quitting smoking? Heh, light up another cigarette! After all, it’s the long run path of your cigarette consumption that really matters. My response would be that there is no better time to start QE than right now. Remember, the longest journey begins with a single step.

OK, let’s all get together now and go after the real enemy—the hawks at the Fed.

BTW, Krugman says his model’s best because he predicted interest rates and inflation weren’t going to rise. Well I predicted interest rates and inflation weren’t going to rise, AND I was screaming at the Fed to ease money in late 2008. How does that call for action look now? Sometimes one needs a relentlessly single-minded focus, and if people consider that Procrustean, so be it.

Lars Svensson is one of the few policymakers who will come out of this debacle with his reputation intact. I’m surprised Krugman hasn’t mentioned him in his blog posts. (They are colleagues at Princeton.)

In Sweden, my former colleague Lars Svensson, now at the Riksbank, is concerned about the desire of his colleagues to raise interest rates in the face of inflation far below target and an economy that is a long way from having fully recovered. But what does he know? He’s just one of the world’s leading monetary economists, having spent a great deal of time studying problems of monetary policy at the zero lower bound.

But that’s not the reason for this post. This is:

Snark aside, the rise of the pain caucus is truly amazing – I’m a hardened cynic, yet even I didn’t see that one coming. As Posen points out, mainstream macroeconomics – which suggests that we need a lot more stimulus, monetary and fiscal – has actually held up very well in this crisis; it has, above all, made the right predictions about inflation and interest rates, while the doctrines underlying the pain caucus have gotten it all wrong. Yet “serious” policy makers are rejecting the theory that works in favor of theories that don’t.

Exactly. And the same thing occurred in the Great Depression. The most respected monetary theories going into the Great Depression were the more progressive price level/NGDP targeting views of people like Fisher, Keynes, Hawtrey, Cassel, Pigou, Hayek, etc. And their predictions of the catastrophic implications of a big drop on the price level and/or NGDP were borne out. And policymakers completely ignored their advice and went with their gut instincts.

Even though I spent much more time studying the Great Depression than Krugman, I was even more wrong about the response of monetary policymakers than he was. (I.e., I was more optimistic.) A triumph of hope over experience on my part.

I always thought the Rawlsian minimax principle was rather odd. Recall that John Rawls once argued that public policies should be implemented if and only if they improved the welfare of those who are worst off in society. I came up with all sorts of bizarre counterexamples, like what if a public policy massively improved the welfare of the top 99%, but slightly reduced it for the bottom one percent. Say it made them $2 worse off. At the time, I never thought my silly thought experiment would ever show up in the data. Until today. I found this graph at Matt Yglesias’ blog:

Yglesias argues that this graph shows that the British public did better under the Labour party than under the Conservatives. He bases that claim on the fact that most of those in the bottom half did better. I have no problem with that argument; it’s based on solid utilitarian reasoning.

As an aside, I still think the Conservatives did more to improve Britain. They inherited a country going down the tubes, and made some very painful decisions to shut down a lot of uncompetitive manufacturing and mining. The made the economy more efficient. They ended double digit inflation. These reforms hurt various sectors of the public, but were needed in the long run. In contrast, Labour inherited an economy in very good shape, and left a fiscal train wreck when they left office in 2010. And a bad recession. Notice the data only goes up to 2008—let’s see how it looks in 2 years when we have the full data showing the Labour government’s entire term in office.

But I digress. My main argument here is that Yglesias is quite rightly ignoring Rawls’ silly maximin principle. The poorest of the poor didn’t do well under the Conservatives (losing about 0.2%), but they did even worse under Labour, losing 1.1%. Rawls would clearly vote Conservative, but for the wrong reason.

If I thought this graph actually captured all the effects of government policy, I’d probably vote Labour. But as I said, my hunch is that Labour was dealt a somewhat better hand. And I think their record will look worse when extended up to 2010.

NEW YORK (Reuters) – Stocks rose on Tuesday after opening lower on weak economic data, with investors saying the data bolsters expectations the Fed will pump more money into the economy, which would support equities.

And what sort of economic data was weak?

September data showed U.S. consumer confidence fell to its lowest level since February, underscoring lingering worries about the strength of the economic recovery, while home prices dipped in July.

Let’s suppose consumers react with a lag to economic data, or suppose the survey was done early in the month. In that case the survey might have reflected the very weak economic data coming out in August (revised GDP at 1.6%, etc) and also a weak stock market, which was partly a response to the weak data.

So let me get this straight:

1. The markets were weak in August, causing a low consumer confidence number in September

2. This leads investors to expect more easing by the Fed

3. This leads to a stronger stock market

4. This will lead to a better consumer confidence number in October

5. Which will lead investors to fear the Fed won’t ease

6. Which will cause stock prices to fall in October

7. Which will lead to a weaker consumer confidence number in November.

8. And so on

Are you getting dizzy yet? This is the so-called “circularity problem,” which occurs when the Fed tries to target market expectations. It was discussed in 1997 in a pair of JMCB papers by Garrison and White, and also Bernanke and Woodford.

The Fed needs to be careful here. It’s easy to say the Fed doesn’t respond to the stock market; but let’s face it, they do. They cut rates after the 1987 crash, even though there was no sign of recession or deflation, and they announced a bond purchase program in March 2009, right after a sickening plunge in equity prices. Make all the jokes about the stock market you want, people do see it as an important indicator of which way the economy is headed. Even if only subconsciously.

So if the Fed were to meet in November and decide not to do QE because the market was looking up, and if the market was looking up because they expected QE in response to weak economic data, then the Fed could end up with a nasty surprise. Something like what occurred in December 2007 and January 2008, or again in September 2008 and October 2008. Using Wall Street lingo, they could “fall behind the curve.”

Of course none of this would be a problem if the Fed used the sort of futures targeting idea I proposed back in 1987 (or similar ideas by people like Dowd, Woolsey, Jackson, etc.) But that’s not going to happen, so they’re going to need to be very careful in evaluating market signals. I almost broke out laughing when I read the first paragraph of that Yahoo story–it’s a near perfect example of the circularity problem.

I worry that the Fed does not fully appreciate the circularity problem. From the WSJ:

Under the alternative approach gaining favor inside the Fed, it would announce purchases of a much smaller amount for some brief period and leave open the question of whether it would do more, a decision that would turn on how the economy is doing. This would give officials more flexibility in the face of an uncertain recovery.

. . .

Markets anticipate the Fed will pull the trigger, barring some surprise turn in the economy. Economists at Goldman Sachs Group Inc. estimate the Fed will end up purchasing at least another $1 trillion in securities, and estimate that would push long-term interest rates down by a further 0.25 percentage point.

A leading public proponent of a baby-step approach is James Bullard, a 20-year Fed veteran who has been president of the St. Louis Federal Reserve Bank since 2008. He says he has made progress convincing his other colleagues to seriously consider that path.

“The shock and awe approach is rarely the optimal way to conduct monetary policy,” he says. “I really do not think it is the right way to go except in really exceptional circumstances.”

These are exceptional circumstances; we’re in a Great Recession. Aggregate demand is expected to remain far too low to allow for a robust recovery. The only way this dynamic can be changed is if the Fed does much more than the markets currently expect. That means shock and awe. It’s a pity it won’t happen.

PS. I notice that Yahoo.com changed the wording of the article I linked to.

Update: Here is an old post that explains why the circularity problem doesn’t occur under NGDP futures targeting.

I keep running across blog posts showing the inequality of income and wealth in America. In a recent post I already discussed one reason why this data is fatally flawed, capital income is nothing like wage income—rather it is deferred consumption. Counting capital income and wage income is actually counting the same income twice. Here I’d like to discuss some other problems with the data:

1. Life cycle effects: I dragged out my annual Social Security data that I get in the mail, and it shows how much I earned during each year. I tried to do a rough adjustment for cost of living changes, to make things fairer (otherwise my income looks extremely unequal.) I am pretty sure my five income “quintiles” are roughly as follows: 3%, 13%, 22%, 27%, and 35%. In other words during my worst 7 years I made 3% of my total real lifetime income, and during my best 5 years about 35%. Some people have a more equal profile, whereas others have a far more unequal profile. I think I’m probably not that atypical. The point is that if we had 100% lifetime equality in earnings, but wages that rose with age and experience, then that’s the sort of income inequality we might observe in America. The actual income inequality is greater, because inequality is not just due to life-cycle effects.

2. Inflation: Suppose you are the richest guy in the world, owning $100 billion in Microsoft stock. You cash out and decide to live off the interest. To avoid inflation risk, you put it all in 10-year indexed TIPS. You would earn $650,000,000 per year in interest. Unfortunately your tax liability would be more than $650,000,000. The government would report your income as about $2 billion. So the person who might well have the highest reported income in the entire country according to official data, might not have any real income at all. Now obviously most rich people don’t put all their money in TIPS. They take bigger risks and get positive rates of return. But risk implies the possibility of loss. Some do much worse than the hypothetical I gave you. Of course even with no income a person this rich has a fabulous lifestyle, which is what I would argue is exactly the point. Look at consumption inequality, not income inequality.

3. I am pretty sure that a lot of the wealth inequality data is incomplete. I recall reading that it often ignores structures (which is much of the wealth for average homeowners and shopkeepers.) It may ignore pensions. Many retired public employees have defined benefit pensions that would be hard to replicate with a 401k holding a million dollars. It ignores human capital, making it impossible to compare human capital-rich brain surgeons and lawyers, with physical capital-rich farmers and landlords.

4. Income inequality data is often collected at the household level, implying that a doctor making $250,000 with a stay at home spouse is no better off that a Boston cop making $150,000 (including lots of overtime) married to a nurse making $100,000 (including lots of overtime.) But the two income couple might have to spend money on child care, and have very stressful lives doing household chores on top of their paid jobs. This isn’t a major bias, but many people who naively think of the top quintile as being “rich” would be shocked at how many working class couples in their 40s or 50s who are dual income and live in high cost areas like NYC and Boston actually fall into that category. I’d guess two married people each making $55,000 would make it the top quintile, and I’d guess a couple who each make $75,000 would make the top decile. Those aren’t gaudy incomes around here.

I am not trying to argue the upper middle class can’t afford to pay more taxes. (I don’t want to get mauled like that poor U of C professor.) Indeed, I think most Americans could afford to pay much more taxes, as we’ve become used to having lots of stuff we really don’t need. A small Hyundai will get us from A to B just as well as a Lexus. So that’s not the point.

Instead, my point is that we should ignore all the official data, and use our eyes. Travel around the country. Go into poor people’s houses. In the 1970s I recall staying with a rural family of six in a small house who had running water for only a couple hours of the day. Over the course of my life I’ve seen lots of poor urban and rural neighborhoods. And I’ve driven around affluent areas like Newport Beach and Wellesey, and very rich areas like Beverly Hills. I don’t really know what’s it’s like to be poor in a cultural sense, or not be able to afford food for my family, but I think I do have a rough sense of the different sorts of consumption bundles purchased by different classes of people. For what it’s worth, here’s my impressions:

1. All classes in America are better off than in the 1960s. But the gains are most noticeable for the poor and rich. Especially the poor in the rural South.

So I don’t have any objection to policies of redistribution, which is what motivates all these comparisons. But it annoys me that people are making arguments using worthless data. Here’s an example of a graph I found in a Matt Yglesias post:

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It shows wealth inequality by quintile, using data that is utterly meaningless, then shows wealth inequality as perceived by the average American. Here you are supposed to laugh at the stupidity of Americans. But their view may actually be closer to the truth than the official data. Then the graph shows the inequality that Americans think would be fair. Even the Bush voters opt for a wealth distribution far more equal than what we actually have.

Here’s the problem with this entire enterprise. Let’s work with the wealth definition that was probably used in this table, that is, only easy to measure financial assets. Assume this data is correct. How much income equality would we need to get things as equal as the Bush voters want? I’m going to claim that even 100% income equality would not be enough. That’s right, if you paid a 16 year old boy with pimples at McDonalds exactly the same income as a brain surgeon at Mass General, measuredwealth in America would still be far more unequal that what Bush voters say we should aim for. That makes Bush voters to the left of Mao, almost at Pol Pot levels of egalitarianism. And the reason is simple. Even with exactly equal incomes, people will vary greatly in how much they save, and how well they invest what they do save. So even with equal incomes, some would become very wealthy, and some would save almost nothing.

With apologies to Bentham, income inequality data is nonsense, and wealth inequality data is nonsense on stilts. It’s all about consumption.

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Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.